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How To Analyze Investment Trusts

A real estate investment trust (REIT) is really a real estate company that offers common shares to the open public. In this way, an REIT stock is similar to every other stock that represents ownership in an operating business. But a good REIT has two unique features: its primary business is managing categories of income-producing properties and it must distribute most of its earnings as dividends. Here we take a look at REITs, their characteristics and that they are analyzed.

The REIT Status
To qualify as an REIT using the IRS, a real estate company must agree to pay out a minimum of 90% of its taxable profit in dividends (and satisfy additional but less important requirements). By having REIT standing, a company avoids corporate income tax. A regular corporation can make a profit and pays taxes on its entire profit, after which decides how to allocate its after-tax profits between dividends as well as reinvestment; an REIT simply distributes all or almost all of its profits and reaches skip the taxation.

Types of REITs
Fewer than 10% of REITs fall under a special class called mortgage REITs. These REITs make loans secured by property, but they do not generally own or operate real property. Mortgage REITs require special analysis. They are finance companies that use several hedging instruments to handle their interest rate exposure. We will not consider them right here.

While a handful of hybrid REITs run both real estate operations and transact in home loans, most REITs focus on the “hard asset” business of property operations. These are called equity REITs. When you read regarding REITs, you are usually reading about equity REITs. Equity REITs often specialize in owning certain building types such as apartments, local malls, office buildings or lodging facilities. Some are diversified plus some are specialized, meaning they defy classification – such as, for instance, an REIT that owns golf courses. (For more understanding, see 5 Types Of REITs and How To Invest Inside them. )#)

Analyzing REITs
REITs are dividend-paying stocks that focus on property. If you seek income, you would consider them along along with high-yield bond funds and dividend paying stocks. As dividend-paying shares, REITs are analyzed much like other stocks. But there are some large differences because of the accounting treatment of property.

Let’s illustrate with a simplified instance. Suppose that an REIT buys a building for $1 zillion. Accounting requires that our REIT charge depreciation against the resource. Let’s assume that we spread the depreciation over 20 years inside a straight line. Each year we will deduct $50, 000 within depreciation expense ($50, 000 per year x 20 many years = $1 million).

Let’s look at the simplified stability sheet and income statement above. In year 10, our balance sheet carries the worthiness of the building at $500, 000 (a. k. the., the book value): the original historical cost of $1 zillion minus $500, 000 accumulated depreciation (10 years x $50, 000 each year). Our income statement deducts $190, 000 of expenses through $200, 000 in revenues, but $50, 000 of the expense is really a depreciation charge.

However, our REIT doesn’t actually spend this profit year 10; depreciation is a non-cash charge. Therefore, we add back the depreciation charge to net income to be able to produce funds from operations (FFO). The idea is that depreciation unfairly reduces our net earnings because our building probably didn’t lose half its value during the last 10 years. FFO fixes this presumed distortion by excluding the actual depreciation charge. (FFO includes a few other adjustments, as well. )#)

We should note that FFO gets closer to income than net income, but it does not capture cash circulation. Mainly, notice in the example above that we never counted the $1 million spent to get the building (the capital expenditure). A more precise analysis would incorporate capital expenditures. Counting capital expenditures gives a figure referred to as adjusted FFO, but there is no universal consensus regarding it’s calculation.

Our hypothetical balance sheet can help us understand another common REIT metric, net asset value (NAV). Within year 10, the book value of our building was just $500, 000 because half of the original cost was depreciated. Therefore, book value and related ratios like price-to-book – often dubious regarding general equities analysis – are pretty much useless for REITs. NAV attempts to change book value of property with a better estimate of marketplace value.

Calculating NAV requires a somewhat subjective appraisal of the actual REIT’s holdings. In the above example, we see the creating generates $100, 000 in operating income ($200, 000 within revenues minus $100, 000 in operating expenses). One method is always to capitalize the operating income based on a market rate. If we think the market’s present cap rate for this kind of building is 8%, then our estimate of the building’s worth becomes $1. 25 million ($100, 000 in operating earnings / 8% cap rate = $1, 250, 000). The forex market value estimate replaces the book value of the building. We then would deduct the mortgage debt (not shown) to obtain net asset value. Assets minus debt equals equity, where the actual ‘net’ in NAV means net of debt. The final step would be to divide NAV into common shares to get NAV per reveal, which is an estimate of intrinsic value. In theory, the quoted share price shouldn’t stray too far from the NAV per share.

Top Lower Vs. Bottom Up
When picking stocks, you sometimes hear associated with top-down versus bottom-up analysis. Top-down starts with an economic perspective and bets on themes or sectors (for instance, an aging demographic may favor drug companies). Bottom-up targets the fundamentals of specific companies. REIT stocks clearly require each top-down and bottom-up analysis.

From a top-down perspective, REITs can have anything that impacts the supply of and demand for home. Population and job growth tend to be favorable for just about all REIT types. Interest rates are, in brief, a mixed tote. A rise in interest rates usually signifies an improving economic climate, which is good for REITs as people are spending and companies are renting more space. Rising interest rates tend to be great for apartment REITs as people prefer to remain renters rather compared to purchase new homes. On the other hand, REITs can often make the most of lower interest rates by reducing their interest expenses and therefore increasing their profitability.

Capital market conditions are also important, specifically the institutional demand for REIT equities. In the short operate, this demand can overwhelm fundamentals. For example, REIT stocks did very well in 2001 and the first half of 2002 despite poor fundamentals, because money was flowing into the entire asset course.

At the individual REIT level, you want to see powerful prospects for growth in revenue, such as rental income, associated service income and FFO. You want to see if the REIT includes a unique strategy for improving occupancy and raising its rents. REITs usually seek growth through acquisitions, and further aim to realize financial systems of scale by assimilating inefficiently run properties. Economies of scale would be realized by a decrease in operating expenses as a percentage of revenue. But acquisitions really are a double-edged sword. If an REIT cannot improve occupancy rates and/or increase rents, it may be forced into ill-considered acquisitions in purchase to fuel growth.

As mortgage debt plays a big part in equity value, it is worth looking at the stability sheet. Some recommend looking at leverage, such as the debt-to-equity ration. However in practice, it is difficult to tell when leverage has turn out to be excessive. It is more important to weigh the proportion associated with fixed versus floating-rate debt. In the current low interest price environment, an REIT that uses only floating-rate debt will be hurt if rates of interest rise.

The Bottom Line
REITs are real estate companies that must pay out high dividends to be able to enjoy the tax benefits of REIT status. Stable income that may exceed Treasury yields combines with price volatility to offer an overall total return potential that rivals small capitalization stocks. Analyzing an REIT requires understanding the accounting distortions brought on by depreciation and paying careful attention to macroeconomic influences.